Inventories and Construction Contracts
Assets
Inventories and Construction Contracts
Syllabus tag: KASNEB CPA | Intermediate Level | CA23 Financial Reporting and Analysis | Topic 4 Inventories and Construction Contracts
Lesson objectives
By the end of this topic, you will be able to:
- Measure inventory at the lower of cost and net realisable value
- Apply that rule line by line and explain why aggregating is wrong
- Compute net realisable value
- Apply FIFO and weighted average and compare their effects
- Explain why LIFO is prohibited
Why this matters
Inventory sits on both statements at once: as an asset on the balance sheet and, through cost of sales, as an expense in the income statement. Every shilling added to closing inventory is a shilling removed from cost of sales and added to profit. That direct link is why the standard is prescriptive.
The measurement rule
Inventory is carried at the lower of cost and net realisable value.
Cost includes purchase price, import duties, transport and handling, and the costs of conversion — direct labour and a systematic allocation of production overhead based on normal capacity.
Excluded and expensed: abnormal waste, storage of finished goods, selling costs, and administrative overhead not related to production.
Note the treatment of overhead absorption. Fixed production overhead is allocated on normal capacity, not actual output. In a month of low production, the unabsorbed overhead is expensed rather than loaded onto fewer units — otherwise a slow month would inflate the value of every unit made.
Net realisable value
NRV = Estimated selling price − Costs to complete − Costs to sell
Goods expected to sell for KES 4,200,000, needing 350,000 of further work and 180,000 of selling costs:
NRV = 4,200,000 − 350,000 − 180,000 = KES 3,670,000
NRV is entity-specific: what this company expects to realise, which is not the same as fair value.
Line by line, not in aggregate
The rule is applied to each item separately.
| Item | Cost | NRV | Lower |
|---|---|---|---|
| A | 2,400,000 | 2,900,000 | 2,400,000 |
| B | 3,600,000 | 3,100,000 | 3,100,000 |
| C | 1,800,000 | 2,050,000 | 1,800,000 |
| Total | 7,800,000 | 8,050,000 | 7,300,000 |
Inventory is carried at 7,300,000, and a write-down of 500,000 is charged.
Compare aggregating: total cost 7,800,000 against total NRV 8,050,000 gives a carrying amount of 7,800,000 and no write-down at all. The gain on A and C would have concealed the loss on B.
That is the whole reason for the line-by-line rule. Unrealised gains may not be used to hide realised losses.
:::checkpoint A company has one product carried above cost and another below. Explain what aggregating the comparison would do to profit, and which accounting concept it would breach. :::
Cost formulas
Where items are interchangeable, a formula is needed.
Opening 2,000 units at KES 480. Purchases 3,000 at 520 and 3,000 at 560. 6,000 units sold, 2,000 remain.
Goods available = KES 4,200,000 across 8,000 units.
FIFO assumes the oldest are sold first, so closing inventory is the most recent purchases:
Closing = 2,000 × 560 = KES 1,120,000 Cost of sales = 4,200,000 − 1,120,000 = KES 3,080,000
Weighted average = 4,200,000 / 8,000 = KES 525 per unit
Closing = 2,000 × 525 = KES 1,050,000 Cost of sales = KES 3,150,000
| FIFO | Weighted average | |
|---|---|---|
| Closing inventory | 1,120,000 | 1,050,000 |
| Cost of sales | 3,080,000 | 3,150,000 |
| Effect on profit | higher by 70,000 |
Identical trading, identical cash, two different profits. In a period of rising prices FIFO always reports the higher profit, because it leaves the newest and dearest units in inventory and charges the oldest and cheapest to cost of sales.
LIFO is prohibited under IAS 2. It does the reverse — charging the newest costs to cost of sales and leaving old, out-of-date costs in the balance sheet, where inventory can end up carried at prices from many years ago.
Construction contracts
Where a performance obligation is satisfied over time, revenue and costs are recognised by reference to progress.
A contract with total revenue KES 48,000,000, expected costs 36,000,000, and costs to date of 21,600,000:
Percentage complete = 21,600,000 / 36,000,000 = 60%
| KES | |
|---|---|
| Revenue (60% × 48,000,000) | 28,800,000 |
| Costs (60% × 36,000,000) | (21,600,000) |
| Profit recognised | 7,200,000 |
Where the outcome cannot be reliably measured, revenue is recognised only to the extent of costs likely to be recovered, and no profit is taken.
Where a loss is expected on the contract as a whole, the entire loss is recognised immediately, however little work has been done. Profits are taken gradually; losses are taken at once.
:::checkpoint A contractor measures progress by costs incurred and buys all the materials for a two-year contract in the first month. Explain what happens to the reported percentage complete and why the resulting profit figure is wrong. :::